Reading the tea leaves on Chinese equities is harder than ever. A sluggish economy, debt woes, and geopolitical tensions have battered shares in the People’s Republic. They could tumble further next year as the world’s second-largest economy flirts with a deflationary spiral. If President Xi Jinping takes decisive action to revive the $18 trillion economy, however, a stunning recovery could ensue. It makes China one of the biggest high-risk, high-reward trades of 2024.
The decline has been startling. Leading benchmarks are close to the lows they plumbed in 2016 following the collapse of China’s epic stock market bubble. The MSCI China Index, which tracks stocks on mainland bourses as well as Chinese companies listed in Hong Kong and New York, is down 15% this year and trades at 9 times forecast earnings for the next 12 months, according to LSEG, half the multiple it commanded when it peaked in 2021. By contrast, the S&P 500 Index has risen by a fifth and is close to its all-time high.
Overseas investors have fled. Global equity funds’ average allocation to Chinese assets stood at 1.75% in September, data from fund flow tracker EPFR shows. That is only slightly more than half the 2.98% weight assigned to Chinese equities in MSCI’s All Country World Index.
Investors have many good reasons to be bearish. Recent disillusionment set in with China’s reopening after the end of Covid-19. Despite mounting signs of economic weakness, authorities in Beijing held back from rolling out the old stimulus playbook. The government has refrained from massive infrastructure spending and is also resisting calls for direct cash handouts to citizens. Instead, Xi has continued his assault on excessive leverage in China’s property sector, which powers a quarter of the country’s GDP.
The gloomy scenario is that China fails to break out of a negative debt-deflation loop like the one that dragged down the Japanese economy in the 1990s and kept it depressed for decades. If Chinese consumers and companies continue to hold back from spending because they think prices will keep falling, earnings will shrink. That will make it harder for all types of borrowers to service debt, further weighing on corporate earnings and valuations.
That could well happen if the government does not step in to stimulate the economy. Consumer prices fell 0.5% year-on-year in November, the fastest drop in three years, due to weak domestic demand. Producer prices have declined for 14 consecutive months.
International investors have additional reasons to shun Chinese equities. For starters, rising US interest rates have sucked capital out of emerging markets: US 10-year Treasury bonds currently yield 152 basis points more than their Chinese equivalents. Xi’s past crackdowns on various sectors, including technology giants Alibaba and Tencent, point to a less lucrative future for Chinese private companies. And officials have a habit of meddling in capital markets: in 2015 around 1,500 companies suspended their stocks in a doomed attempt to halt a selloff. Recent efforts to encourage a “national team” of state and private companies to prop up the stock market have had little visible success.
Geopolitical risk has also become too big to ignore: Washington is trying to curb China’s technological advancement while Beijing is retaliating with export controls. International investors fear they will get caught in the crossfire. Another concern is that if China invades Taiwan, resulting Western sanctions could leave money managers with frozen assets – a painful lesson they learned in Russia in 2022.
A BIG COMEBACK
Yet any revival in Chinese stocks does not depend on foreign capital: outsiders own just 4% of mainland shares. Domestic retail traders dominate the Shanghai and Shenzhen bourses, whose combined market capitalisation is almost $11 trillion. They are sitting on piles of savings and love to gamble.
China’s ageing population also lacks reliable places to park its wealth. Household savings in China have ballooned by 70% to 135 trillion yuan ($18.8 trillion) since the pandemic started. Yet housing, once the preferred investment, looks less assured with millions of homes unfinished and debt problems dragging down top developers including China Evergrande and Country Garden.
Xi has also cracked down on wealth management products as he attempts to stem financial risk.
China’s captive pool of domestic capital is one reason shares in big Chinese companies listed on mainland exchanges command a hefty 51% premium to their equivalents in Hong Kong, 13 percentage points more than at the start of 2023. It is also why international brokers increasingly recommend trading Chinese equities onshore rather than offshore.
If the property market stabilises, domestic investors could return quickly. Authorities could fast-track such an outcome by channeling additional support towards redeveloping “urban villages” in big cities.
If Xi’s war on leverage also convinces Chinese citizens of his belief that “houses are for living, not for speculation,” they might hoard less cash for deposits on real estate purchases, freeing up spending for consumption. And if the US Federal Reserve lowers interest rates, which the central bank on Wednesday signalled looks likely to happen next year, and geopolitical tensions ease, some overseas investors may come back.
The best case for Chinese equities, however, may be that there is no strong relationship between economic growth and stock price performance. Real inflation-adjusted US dollar returns for Chinese stocks have lagged the DMS World index by 1.5% per year since 1993, even as the country’s real GDP grew by 9% annually over roughly the same period, data from the Credit Suisse Global Investment Returns Yearbook shows. This may mean that the benefits of China’s economic growth do not flow to equity investors. However, it also implies that a slowing economy does not necessarily mean a sluggish stock market.
The outlook for 2024 is therefore one of extremes. Strategists at Morgan Stanley reckon the MSCI China Index could rise by as much as 23% or fall by as much as 36% in the next 12 months. The 59-percentage-point spread between the optimistic and pessimistic scenario is much larger than the 41-percentage-point spread the US bank envisages for constituents of Japan's Topix index, where uncertainty lingers about when and how the central bank will unwind almost a quarter century of ultralow interest rates.
There are many good reasons for domestic and international investors to keep shunning Chinese stocks. Yet it is also relatively easy to be underweight a market that is underperforming. Any revival would force investors to revisit their assumptions. For those with a stomach for a high-risk, high-return trade, there is scope for a long march upwards. — Reuters
Una Galani is Asia Editor of Reuters Breakingviews, based in Mumbai. She was previously in Hong Kong and Dubai.
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